Lecture 4 - Cost and Time Planning Flashcards
What are the two ways in which costing approaches can be derived?
- Top-down costing.
2. Ground-up costing.
Describe top-down costing:
- Budget set by people who negotiate with the clients.
- Budgets may be too optimistic; no buy-in from project team.
- Project manager allocates budgets to sub-projects.
- Costs fixed externally to project.
Describe ground-up costing:
- Budget set by those who actually do the work.
- Can lead to inflated budgets and renegotiation with senior management.
- Risk of missing work packages.
- Project manager collates estimates.
- Costs set by the project.
Give examples of ‘direct costs:
- Salaries and wages
- Materials, machinery (usage costs)
- Third party services (consultants)
- Other expenses: travel and accommodation.
Give examples of ‘indirect costs:
- Overhead costs for general management (e.g. office space, training, typically % of direct costs).
Give examples of ‘below the line costs:
- Contingency for unexpected costs (% of direct & indirect costs).
- Profit mark-up (if sold to external clients).
What technique is used to estimate the cost of projects?
Parametric Estimation.
Describe ‘parametric estimation’:
For “as … but …” and “painting by numbers” projects:
- Determine major cost factors in previous projects
- Use regression model to estimate costs of current project based
on previous projects (e.g. via multi-variate regression analysis)
For “first timer” and “as … but …” projects:
- Forecast cost factors, units and per-unit costs in each WP
- Aggregate costs over all work packages in the WBS.
Define ‘payback period’:
The amount of time that is required for the project to “pay
itself off”, i.e., until revenues break even with costs.
Payback criterion: prefer projects with shorter payback period
What are the advantages of the payback analysis?
- Criterion is easy to understand and in widespread use.
- Future payments are subject to higher uncertainty.
What are the disadvantages of the payback analysis?
- Costs/benefits beyond payback period are ignored.
- Long-term benefits for the company
- Decommissioning costs at end of lifetime - Time value of money (“£1 today is worth more than £1
tomorrow”) is ignored.
- See discounted cash flows and internal rate of return - Only useful for comparing different projects.
- By itself, it does not say whether project is valuable or not
Define ‘cash flow’:
Any money movement into or out of the company:
- Revenues generated by the project
- Costs incurred by the project
Define ‘present value of a project’:
Sum of present values of all project-related cash flows (“cash equivalent” of project).
What is the explicit expression for the PV of a project?
PV = CF0 + CF1 x (1 + i)^-1 + …
What are the advantages of the discounted cash flow method?
PV criterion:
- Project is only viable if its present value is positive
- Choose project(s) with highest present value(s)
Advantages:
- Allows evaluation of single project and comparison of projects
What are the disadvantages of the discounted cash flow method?
Unclear which interest rate to use.
- Interest rate offered by bank?
- Weighted average cost of capital?
Interest rate may change over time; difficult to forecast
- Does not reveal anything about rate of return.
Define the ‘internal rate of return’:
Internal rate of return: interest rate that makes present value = 0
What are the advantages of the internal rate of return?
IRR criterion:
- Project is only viable if IRR exceeds cost of capital
- Choose project(s) with highest IRR(s)
Advantages:
- Allows evaluation of single project and comparison of projects
- Accounts for the time value of money, as well as rate of return
What are the disadvantages of the internal rate of return?
Unclear how to choose cost of capital.
IRR may not be unique for given cash flow stream.
- Guaranteed to be unique if first cash flow is negative, and remaining cash flows are all positive.
Implicit assumption that money can be reinvested at IRR.
What are the 4 challenges of financial analysis?
Financial appraisal is only one side of the coin.
- Strategic benefits (e.g. organizational change, future products)
- Non-profit organizations (e.g. disaster relief projects)
- Ethical or environmental concerns (e.g. labour reduction)
Cash flows may be difficult to estimate.
- Especially in projects with high uncertainty
“Optimism bias” in business cases.
- “Understated costs + overstates benefits = project approval”
Positive/negative interactions with other projects.
- Synergies between different projects.
- Cannibalising products in a narrow market.
